In Defense of VC Pattern Recognition

The notion of venture capital best practices is nothing new. For some time now, I’ve enjoyed the back and forth between venture practitioners and entrepreneurs about what constitutes the elements of good process and cogent thinking in venture decision-making. Codifying a venture process or methodology has stymied many a well-meaning firm over the years. While there are certain processes and approaches that most firms would recognize as well-reasoned, there still exists wide disagreement among venture investors and the firms they helm about what should drive investment decisions, how much rigor and analysis should play into investment decision-making versus old-fashioned gut instinct and momentum-style approaches, and what ideal blend of background, experience and temperament makes for a successful venture capitalist. The answers aren’t so obvious.

For me, one of the exciting elements of venture also happens to be one of the areas of greatest frustration — to both those in the field and those outside the glass. That frustrating element is the intangible, unstructured and fickle nature of the venture business. The cliché about venture career paths — that to ask ten VCs how best to enter the venture business would elicit ten very different responses — has persisted for the simple reason that it is an accurate depiction of how circumstantial the venture business is. Hollywood agents may have their William Morris Agency mailroom farm league system to help groom aspiring agents-to-be (and weed out the dreamers), but no such finishing school exists for the Sand Hill Road or Route 128 set. Founding and operating a start-up is probably the most obvious and germane way to learn the mechanics of start-up operations and to develop the skills that, later on, will prove invaluable as an advisor to other startups. That said, a succesful entrepreneurial career is no guarantee of subsequent success as a venture investor. Indeed, some of the industry’s most successful venture capitalists never spent a day in a start-up, so go figure. 

Correspondingly, just as there exists no feeder school to a venture career, there is no tried-and-true approach to hone good decision-making by both aspiring and practicing venture investors. Into this debate the notion of pattern recognition has been both praised and derided. For some it is a valuable tool — some might say skill —  to help investors separate wheat from chaff. It can frame for an investor likely outcomes from past experiences with similar companies, similar approaches, similar strategies and similar team compositions. Detractors would argue that pattern recognition is not really a skill at all, just an accumulation of trade practices and a prism steeped in groupthink through which venture investors view opportunities freed from truly independent thought and creativity. The problem with pattern recognition as a technique to evaluate an opportunity, the argument would go, is that it is not only a bad substitute for independent thinking, it prematurely nips in the bud potentially promising opportunities by unfairly punishing them for the past failures of companies that came before with similar concepts.

To be fair, that’s not a bad point. Sure, the fact that the last ten companies that pitched me trying to do a GPS-enabled location-based gaming app focused on dog groomers came to nothing doesn’t necessarily mean your company won’t be the next Google. Some start-up team, it could be argued, will finally succeed in that space and that team could just as easily be yours — but I wouldn’t bet on it.

From my perspective, both camps are right to a certain extent. Like any tool, pattern recognition can be too heavily relied upon and can improperly take the place of real thinking and analytical rigor. So, to the extent we are discussing deal evaluation at the earliest stage, I would wager that many investors do prematurely jettison opportunities because their perspective is skewed by knowledge of prior stumbles by earlier market entrants. The more nuanced approach, I would wager, is to more heavily weigh the attractiveness of the space the company is focused upon over the company itself in the initial stages of evaluation. If the investor believes wholeheartedly in the space and is not dissuaded by the fact that so many earlier entrants failed trying to build a business there, then the discussion revolves around whether that investor wants to invest in that space and whether that particular company can succeed. Any forthcoming investment decision, or so goes the hope, will be made based upon the merits of the company and its solution and not upon the number of carcasses on the battlefield from prior attempts to “take that hill.”

To my mind, perhaps the greatest value of pattern recognition is simply a function of robust deal flow. Seeing a LOT of opportunities in a given space is invaluable and absolutely critical to long-term success in a particular area. Sure, there always exists the one-off moonshot opportunity that can land in a venture investor’s lap that becomes the next juggernaut in the space, but the more typical scenario behind most venture success stories is one of a methodical investor meeting every company in the space, learning the idiosyncracies of the ecosystem, and then partnering with the company that that investor believes has the right combination of team, solution, and timing to become a market leader. The pattern recognition that develops in that process, obviously, is a function of seeing so many opportunities in the space, weighing their pros and cons, and getting past the initial frisson and excitement of what every company is doing — and, hence, being dispassionate about the investment selection process itself. I find pattern recognition, as a tool, far less effective as a company matures and the relationship with that company deepens. I have been on great boards and dysfunctional ones; I’ve advised talented CEOs that commanded the respect of everyone in their organizations and I’ve worked with CEOs who couldn’t run a lemonade stand. While I have learned from each of these experiences I find these lessons rarely apply cleanly to subsequent problems. Companies, like people, are unique and applying a rote process or management algorithm for specific eventualities based upon how earlier crises were managed rarely works effectively.

More Musical Chairs on Sand Hill Road

Time was (and that time was not all that long ago) that the departure of a recognized general partner/managing director at a similarly recognized venture firm would be a buzzworthy 2-3 day story within venture circles.  Turn that “departure” tale into one where the departure involved that same investor joining a competitor firm and tongues would be wagging for some time.

In just the past few days, word has come out of the NVCA annual meeting that not one, but at least four, well-known and well-respected GP-level investors have left their respective firms to — in most cases — join a rival firm. If not unprecedented, this revelation certainly strains my memory to recall anything remotely similar in recent years. To be sure, partners retire. Other times, particularly when a firm has suffered poor returns or during a market downturn, partners are sometimes asked to, ahem, “make other career arrangements.” This is often so the firm can retrench or reposition itself; it can also just be because of a strategy shift or because there has been internal rancor in the partnership for some time and, as such, a decision was reached to make a change.  

Regardless of the particular circumstances, in virtually all cases there have been carefully planned transitions and sealed lips on where things went off the rails in these investor-partnership relationships. “Smiles and handshakes all around” is often the party line.

While I send my best wishes to all those investors who have recently moved to new firms, I do ask myself whether this is a harbinger of things to come in the industry. To state that many partnerships have been under strain in the past year is to state the obvious to anyone with regular dealings in this industry. Conventional thinking has long held that continuity is critical in investment partnerships. I think that belief is going to be strained. It is a truism that many limited partnerships, when considering an investment in a venture fund, look at the continuity and ties of the investment team. This is particularly the case when you are talking about venture funds that typically have a 10-year life. That said, with this spate of recent departures — and the community’s response to them by taking the news in stride, for the most part — one has to wonder whether we are entering a new period in the venture community where “moving across the street” from one firm to another much in the traditional style of investment bankers or corporate attorneys will become the norm in the venture community. I don’t have a crystal ball here, but I am anxious to hear other people’s viewpoint.

A (final?) word on NDAs

Several times a month an entrepreneur I am intending to meet with hits me with an NDA demand. Often this happens over email so I find myself tapping out a reply where I itemize the reasons why I (and most of my venture colleagues) rarely sign NDAs, and why, in most cases, an entrepreneur should not even ask for one. I have tapped out the same ‘why I don’t sign NDAs’ content so many times that I now simply dig through my Sent Items folder and locate the most recent response I sent on this topic to the last entrepreneur who asked for an NDA, and I cut and paste it into my current reply.

What I find interesting is that there is a veritable banquet of information online and in book form for entrepreneurs about the mechanics of launching a start-up. Indeed, folks like Guy Kawasaki, have almost carved out an entire cottage industry of How-To manuals and seminars on navigating the rocky shoals of entrepreneurship successfully. I think highly of Guy and others like him who have laid a foundation of good insights and information for entrepreneurs to leverage. With all that information, however, the NDA question seems to come up more than most. As such, I thought a post on this subject was in order.

Foundry Group’s Seth Levine covered this subject recently, as have many VC bloggers over the past few years. Their posts are worthwhile reading. That said, here are my specifics in layman’s terms on why entrepreneurs should think carefully about bringing up this subject next time a meeting with a venture capitalist is in the offing.

1. The Urban Legend issue. I am not sure where this all started, but there remains a persistent fear among some entrepreneurs (usually the first-timers) that VCs steal ideas from entrepreneurs with abandon. For some entrepreneurs, this paranoia is so palpable that they simply cannot get past it. Unfortunately, this unhealthy pre-occupation ends up precluding them from getting any help from potential advisors, investors, and others who might actually like the idea and help the entrepreneur become successful. Too often, the end result is that the idea dies, unfunded and unrealized due to irrational fear and paranoia.

Have their been occasions in the past when some VCs have behaved unethically or inappropriately with sensitive information imparted by an entrepreneur? I am sure that there were such occasions, but I have never seen it on my watch, I have never heard any verifiable accounts of any note, and I doubt highly that it goes on nowadays with the many firms I collaborate with on investments, ideas or due diligence.

For one reason, it’s a career killer. VCs live and die in large part based upon their reputations in the community. Good reputations breed good relationships with fellow VCs, entrepreneurs, and partners. Those good relationships then breed good deal flow and a network of people to collaborate with on other investments. One clumsy attempt to ‘steal’ an idea from an entrepreneur will all but assuredly kill that venture investor’s career and virtually anything he or she touches. In short, it would be an absurdly dumb move.

Secondly, most venture capitalists are simply too busy working with their portfolio companies, managing their limited partner relationships, and balancing hectic lives to simply run off and start a company. Last I checked, a career in venture, if you are fortunate enough to build one, has a lot to recommend it. I love what I do and would wager that I speak for many of my colleagues in that regard. I, for one, certainly have no intention of leaving everything I have built over the past 15 years to steal someone else’s business idea, no matter how compelling. It would be much better to find a way to partner together and see this idea to fruition.

2. The Liability issue. For most venture investors, signing NDAs can only expose us to liability.  I probably meet with 200 companies a year and review investor collateral for another 200 or so. That figure is probably typical for a partner at an early stage venture fund. If I signed NDAs for every entrepreneur that requested one, I would never get anything else accomplished. Simple numerical probabilities dictate that eventually I am going to meet with another company that is intending to do something similar to a company that I have met with previously. [There are few “truly” original ideas out there, the saying goes.] Should I decide to subsequently invest in that company, then I and my fund would be exposed to litigation by an entrepreneur whose appeal for funding I may have earlier spurned and/or who is now convinced that I either stole his idea outright or I am using the “confidential” information he shared with me with the new company we just funded. In either instance, my fund and I now have an expensive lawsuit to grapple with, regardless of its questionable merits.

3. The Adverse Selection problem. We call this the “adverse selection” problem because oftentimes the companies that seek an NDA from us most aggressively are the ones that usually “have” very little–hence, their perceived compulsion to protect their largely unprotectable idea. The question it begs here is that ‘if your idea is that easy to steal, then there probably wasn’t much there of interest to us anyway.’ This is a subtle but important distinction for entrepreneurs to understand. Any experienced professional investor knows that if a portfolio company begins to gain traction, competition is a given. Indeed, in so many markets, competitors are almost literally lurking in the shadows watching while the early entrants validate the market and (hopefully) stub their toes. In short order, the marketplace is teeming with me-too companies and other competitive threats. If a portfolio company’s business is so easily stolen in such an eventuality, then someone wasn’t doing their homework at the venture fund.

Now, to be sure, there are times and circumstances where NDAs are absolutely a requirement and where they should come into play. Meetings with potential joint venture partners and/or certain vendors is one obvious place where NDAs should be considered. Another circumstance would be when a company has very specific and very sensitive technologythat could be enormously compromised by its disclosure. Truth be told, we see perhaps three or four companies a year where the technology is in such a state that an NDA would be appropriate. The rest of the time, the NDA request only serves to send the wrong message to investors and bogs down the process.

Like in most circumstances when pitching businesses to investors, your mileage may vary. In other words, a good entrepreneur needs to assess the circumstances he or she is operating within and decide what demands and burdens he wants to place on his prospective investors. Too many, and he sends the message that he is a naive entrepreneur that has both failed Entrepreneurship 101 and will likely need a lot of hand-holding down the road. Given how busy most of the good venture investors are already with their existing commitments, that alone can sink a prospective investment.

Earn Your Wings

Without hesitation, I can estimate that I find myself twice monthly responding via email to a query from an aspiring venture capitalist. The question always carries with it some inconsequential variation, but it can typically be surmised as follows: “How do I get a job/begin a career in venture capital?”

The tired bromide that ‘to ask ten venture capitalists how they entered the business is to get ten (very) different responses’ is an accurate one — perhaps, stubbornly so. I believe this has just as much to do with the humble and ragtag origins of what we now consider the modern-day US venture capital industry as it does with the intrinsic speed with which the overall technology industry is evolving, growing and adapting to new market realities at an ever-increasing pace. That said, the venture capital ‘profile’, for lack of a better word, has remained inarguably broad.

Reid Dennis, the legendary venture investor of IVP fame, is a venture conference fixture and is often asked to re-tell his stories of how, in the early 1960s, he and a rogue’s gallery of “angel” investors — most often Reid’s buddies in the San Francisco Financial District establishment — made their earliest investments from a back booth at Jack’s on Sacramento Street into companies that would later form the fabric of the west coast tech industry. Typically, a budding entrepreneur would be hosted to a martini lunch where he (and it was always a ‘he’) would be peppered with 20 minutes of Q&A. After a bit, the entrepreneur would be asked to wait outside the restaurant while the investor group debated the deal. In usual fashion, the “round” would come together when one of those in attendance would inevitably say, “What the heck, I’m in for $10k,” which would then be followed by a chorus of “Yeah, put me down for $15k” and the like until the round was closed. No three-hour conference calls with Wilson Sonsini, no 90-day no shops and due diligence binders. That was how deals got done.

The “investor group” ran the gamut from serial entrepreneurs with multiple successes under their belts who were looking for exciting new invesments, to semi-retired corporate executives who liked the investment game, to investment bankers and tax lawyers who never spent as much as a day slogging away at a startup.

The intervening years brought the gradual “institutionalization” of venture capital as firms such as Mayfield in the late ’60s, and KP and Sequoia in the early ’70s began to come together in a formal sense and pursue these investments in a more structured, less seat-of-the-pants manner. Through the subsequent booms and busts, there were evident tendencies whereby firms might shuffle the deck to focus on, say, more technical partners to replace softer-skilled ones so as to better understand emerging “hard” technologies, or, in later years, to bring on consumer internet-knowledgeable partners to pick up the slack (or outright replace) more ‘idle’ partners in busted or out-of-favor sectors where opportunities were few, far between, and not terribly attractive. That said, the professional breadth at many top firms remained “democratic” in their diversity of talent and their bench strength.

That said, for the benefit of the freshly minted MBA or career changer intent on a career in this field, I can only offer my qualified opinion — and it is just my opinion — that given where the industry is and where I feel it is headed, having hands-on operating experience at a startup (or three) is going to become especially valued at the more established firms. [For what it is worth, my firm, Citron Capital, has made it an unspoken requirement that anyone it brings on have hands-on operating experience at an early stage company. That has been an understanding since the formation of the fund and is not likely to become less emphasized in its hiring practices going forward.]

This is not to say that ‘other’ experiences are minimized. Let me be the first to say that I have worked with and alongside many successful and highly competent venture investors who, truth be told, never put in a day at a start-up. However, I would venture a guess that those same investors might struggle to point to their days in a 40th floor conference room assembling investment banking pitchbooks or writing industry reports as being the formative ones that they still draw from each day in helping early stage companies (Ask me how I know.) Investment banking, management consulting and corporate development roles are excellent training grounds for a wide swath of career paths, but there is something true and visceral about having slogged up and down I-280 or Hwy 128 raising funding, building a mangement team, bringing a product to market, and taking a company from zero to 60 (or, too often, from zero to 60 to zero. Again, ask me how I know.)

So, my principal advice is to do something bold. Take some risk. Leave the comfy confines of the 40th floor conference room at the investment bank/consulting firm/corporate development group and get some real start-up experience. Either be a founder or join a company at a stage that is still embryonic enough where you can have some real impact. If you do join the ranks of venture capitalists later in life, you will undoubtedly draw from that experience almost daily as you then begin to advise those young entrepreneurs about all the mistakes they are about to make that you know so well. After all, does it not follow that a chief component of a venture capitalist’s role (particularly an early stage one) is to advise and mentor young founders?

The second suggestion is fairly common-sensical. This is a relationships business. Few venture firms ever hire someone they do not already know in some capacity. That does not mean carpet-bomb the email InBoxes of every partner on Sand Hill Road asking for informational interviews. What it does mean is to make yourself valuable, nay, indispensible to those in The Life. Pick an area of expertise and deeply understand it, know the players (deal flow is a must in this business), have conversational expertise in the technology, and know about which firms are doing what deals and why. If you can advise a venture investor on an emerging area you know well. or find a way to run down deals that they might be looking at, do it. Networking is great, but when you do it, remember the old saying about asking for a bank loan when you don’t need the money. [During the last informational interview I granted, the young chap was relentless in his desire to impress upon me how much he wanted a venture job. Basically, he did everything but hump my leg.]  

In other words, if you are legitimately just trying to meet new investors and not doing the full-court press for a job, great. You will be more successful.

At least when it comes to landing venture roles, success is attracted not pursued.